The term leasehold is used to describe the contractual agreement between the lessor and lessee. The leasehold agreement grants the lessee the right to use of a specific property, for a specific period of time, in return for the agreed-to payment terms.
Explanation
Most lease agreements are fairly straightforward, and provide the lessee access to a specific property in exchange for what are typically cash payments. The agreement between the lessee and lessor will specify payment terms, timelines, as well as the exact use rights to the property.
There are several situations that need to be addressed as part of the accounting cycle:
Capitalization: if a lease transfers substantially all of the benefits and risks associated with owning the property to the lessee, it may be classified as a capital lease. As such it must be recorded on the balance sheet as a tangible asset, and depreciated in a manner that is consistent with the lessee's accepted depreciation methods.
Prepayment: if payment is made in advance, the prepaid rent needs to be allocated to the associated accounting periods. This prepayment can be a lump sum representing payment in full or a down payment. Prepayments are usually classified as a deferred charge.
Leasehold Improvements: if the lessee decides to expand, reconstruct, or otherwise dedicate monies to the improvement of a leasehold agreement, this improvement becomes the property of the lessor at the end of the agreement. Leasehold improvements are generally classified as property, plant and equipment. As such, these assets are depreciated over their useful lives or the remaining life of the agreement, whichever is shorter. A lease may contain a clause allowing the lessor to extend the agreement. If the likelihood of extending the agreement is certain, the improvement can be depreciated over the serviceable life of the improvement or the extended lease agreement, whichever is shorter.
The income statement is a financial accounting report that demonstrates how net income, or profit, is derived from revenues. The main categories appearing on an income statement include revenues, cost of goods sold, operating expenses, non-recurring items and net income.
The term expense is used to describe the outflow of money to pay for a product or service. In financial accounting, expenses are defined as the cost of goods sold, or services used up, in the process of producing revenues for a company. The expenses of a company are reported on the income statement.
The financial accounting term depreciation is sometimes defined as a decline in tangible plant's service potential. Depreciation is a method of allocating the cost of a tangible asset in a systematic manner to those time periods that benefit from the use of the asset.
The financial accounting term intangible asset is used to describe those assets that lack physical structure (they cannot be seen or measured), and have a high degree of uncertainty surrounding future benefits to be derived from them. The most common types of intangible assets appearing on the balance sheet are goodwill, copyrights, trademarks, patents, franchises, and organization costs.
The Financial Accounting Standards Board rules allow companies two methods to account for leases. If the agreement meets any of the following conditions, the lease should be treated as a capital lease, also known as a finance lease:
The financial accounting term prepaid expense refers to the portion of an advance payment that has not been used up at the end of an accounting period. Prepaid expenses are an asset and appear on a company's balance sheet.
The financial accounting term property, plant, and equipment is used to describe assets of a long lasting nature, which are used in the normal operation of the company. The most common types of property, plant, and equipment are land, buildings, and machinery.
The financial accounting term service life is used to describe the period of time over which an asset can be expected to perform its intended use. Service life is typically limited by two factors: physical wear and obsolescence.